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Learning Objectives
Understand the importance of workingcapital.
The liquidity-profitability trade-off. Determining the optimal level of
current assets.
The risk and return implications ofalternative approaches to workingcapital financing policy.
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The Importance of Managing and
Accumulating Working Capital
Working capital is the amount of thefirms current assets: cash, accounts
receivable, marketable securities,inventory and prepaid expenses.
Managing the level and financing ofworking capital is necessary:
to keep costs under control (e.g. storage ofinventory)
to keep risk levels at an appropriate level(e.g. liquidity)
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Managing Current Assets
& Liabilities Net Working Capital
= Current Assets - Current Liabilities
Determining the Correct level of WorkingCapital Balance Risk & Return
Benefits of Working Capital Higher Liquidity (Lowers Risk)
Costs of Working Capital Lower Returns - $$ invested in lower returning
securities rather than production.
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Firm 1
ST Debt 100LT Debt 400Common Stock 500Total Liabilities&Equity 1000
Firm 1Marketable Securities 0Other Current Assets 200
Fixed Assets 800Total Assets 1000
Firm 1Operating Earnings 150
Interest Earned 0EBT 150Taxes (40%) -60Net Income 90
Example: Risk-Return Trade-off
Compare the 2 following companies
Current Assets
Current Liabilities
Current Ratio =
200100
=
= 2Current Ratio 2
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Firm 1
ST Debt 100LT Debt 400Common Stock 500Total Liabilities&Equity 1000
Firm 1Marketable Securities 0Other Current Assets 200
Fixed Assets 800Total Assets 1000
Firm 1Operating Earnings 150
Interest Earned 0EBT 150Taxes (40%) -60Net Income 90
Current Ratio 2
Return on Assets =Net Income
Assets
901000
=
Example: Risk-Return Trade-off
Compare the 2 following companies
= .09 = 9%
ROA 9%
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Firm 2:
$200 Marketable SecuritiesFinanced with Common Stock
200 x 4% = $8 interest earned
Firm 1 Firm 2
Marketable Securities 0 200Other Current Assets 200 200
Fixed Assets 800 800Total Assets 1000 1200
Firm 1 Firm 2
ST Debt 100 100LT Debt 400 400
Common Stock 500 700Total Liabilities&Equity 1000 1200
Firm 1 Firm 2Operating Earnings 150 150
Interest Earned 0 8EBT 150 158Taxes (40%) -60 -63Net Income 90 95
Current Ratio 2
ROA 9%
Example: Risk-Return Trade-off
Compare the 2 following companies
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Firm 1 Firm 2
Marketable Securities 0 200Other Current Assets 200 200
Fixed Assets 800 800Total Assets 1000 1200
Firm 1 Firm 2
ST Debt 100 100LT Debt 400 400
Common Stock 500 700Total Liabilities&Equity 1000 1200
Firm 1 Firm 2Operating Earnings 150 150
Interest Earned 0 8EBT 150 158Taxes (40%) -60 -63Net Income 90 95
Current Ratio 2
ROA 9%
400100
=
Current Ratio = CA
CL
Example: Risk-Return Trade-off
Compare the 2 following companies
= 44
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Firm 1 Firm 2
Marketable Securities 0 200Other Current Assets 200 200
Fixed Assets 800 800Total Assets 1000 1200
Firm 1 Firm 2
ST Debt 100 100LT Debt 400 400
Common Stock 500 700Total Liabilities&Equity 1000 1200
Firm 1 Firm 2Operating Earnings 150 150
Interest Earned 0 8EBT 150 158Taxes (40%) -60 -63Net Income 90 95
Current Ratio 2 4
ROA 9%
951200
=
Example: Risk-Return Trade-off
Compare the 2 following companies
=.079 = 7.9%
7.9%
Return on Assets =NI
Assets
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Firm 1Higher ROALess LiquidRiskier
Firm 2Lower ROAMore LiquidLess Risky
Example: Risk-Return Trade-off
Compare the 2 following companies
Firm 1 Firm 2
Marketable Securities 0 200Other Current Assets 200 200
Fixed Assets 800 800Total Assets 1000 1200
Firm 1 Firm 2
ST Debt 100 100LT Debt 400 400
Common Stock 500 700Total Liabilities&Equity 1000 1200
Firm 1 Firm 2Operating Earnings 150 150
Interest Earned 0 8EBT 150 158Taxes (40%) -60 -63Net Income 90 95
Current Ratio 2 4
ROA 9% 7.9%
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Time
Total Assets
Assume ZERO Long-term Growth
$5M
Variation in assets over time
FixedAssets
}
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Time
Total Assets
FixedAssets
Permanent
Current Assets}
}$5M
$7M
Variation in assets over time
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Temporary Current Assets
Variation in assets over time
Time
Total Assets
Fixed
Assets
Permanent
Current Assets}
}
$5M
$7M
$10M
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Different Approaches to Financing
Conservative Approach
Finance all fixed assets, permanent current assets,
and some temporary with LT debt or equity. STfinancing is used for the remaining temp. currentassets.
Lower risk, lower return
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Financing Current Assets:
Conservative Approach
Temporary Current Assets
Time
Total Assets
Fixed
Assets
Permanent
Current Assets}
}
$5M
$7M
$10M
Temporary Current Assets
Time
Total Assets
Fixed
Assets
Permanent
Current Assets}
}
$5M
$7M
$10M
Short-term
Sources
Long-term
Sources
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Different Approaches to
Financing Conservative Approach
Finance all fixed assets, permanent current assets,and some temporary with LT debt or equity. STfinancing is used for the remaining temp. currentassets.
Lower risk, lower return
Moderate Approach (Maturity Matching) Finance fixed assets and permanent current assetswith LT funds and temporary current assets withST funds.
Moderate risk, moderate return
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Financing Current Assets:
Moderate Approach
Temporary Current Assets
Time
Total Assets
FixedAssets
Permanent
Current Assets}
}$5M
$7M
$10M
Temporary Current Assets
Time
Total Assets
FixedAssets
Permanent
Current Assets}
}$5M
$7M
$10M
Long-term
Sources
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Financing Current Assets:
Moderate ApproachShort-term
Sources
Temporary Current Assets
Time
Total Assets
Fixed
Assets
Permanent
Current Assets}
}$5M
$7M
$10M
Temporary Current Assets
Time
Total Assets
Fixed
Assets
Permanent
Current Assets}
}$5M
$7M
$10M
Long-term
Sources
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Different Approaches to
Financing Conservative Approach
Finance all fixed assets, permanent current assets, and sometemporary with LT debt or equity. ST financing is used forthe remaining temp. current assets.
Lower risk, lower return
Moderate Approach (Maturity Matching) Finance fixed assets and permanent current assets with LT
funds and temporary current assets with ST funds.
Moderate risk, moderate return
Aggressive Approach Finance all temporary current assets, permanent current
assets, and some fixed assets with ST debt. LT financing isused for the remaining fixed assets.
Higher risk, higher return
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Long-term Sources
Financing Current Assets:
Aggressive Approach
Temporary Current Assets
Time
Total Assets
Fixed
Assets
Permanent
Current Assets}
}$5M
$7M
$10M
Temporary Current Assets
Time
Total Assets
Fixed
Assets
Permanent
Current Assets}
}$5M
$7M
$10M
Short-term
Sources
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Managing (WARM, SOFT) Cash
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How much cash should a
firm keep on hand? Managers must keep enough cash to
make payments when needed.
(Minimum balance) But since cash is a non-earning asset,
managers should invest excess returns
and keep just the amount of cash thatis necessary.(Maximum balance)
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The size of the minimum
cash balance depends on: How quickly and cheaply a firm can
raise cash when needed.
How accurately managers can predictcash requirements.
How much precautionary cash the
managers need for emergencies.
Link to Dun & Bradstreet
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The firms maximum cash
balance depends on: Available (short-term) investment
opportunities e.g. money market funds, CDs, commercial
paper Expected return on investment opportunities
(opportunity cost) If high expected return, firms are quick to invest
excess cash
Transaction cost of withdrawing cash andmaking an investment
Link to Bureau of Economic Analysis
http://www.bea.doc.gov/http://www.bea.doc.gov/http://www.bea.doc.gov/http://www.bea.doc.gov/ -
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Choosing the Optimum CashBalance
Days of the Month
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
Cash Balances in a Typical Month
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| | | | | | | | | | | | | | | | | | | | | | | | | | | |
Cash Balances in a Typical Month
Choosing the Optimum CashBalance
Invest Excess
Cash
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28Days of the Month
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
Cash Balances in a Typical Month
Choosing the Optimum CashBalance
Sell Securities toobtain cash
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The Miller - Orr Model
The Miller-Orr Model provides a formula fordetermining the optimum cash balance, the
point at which to sell securities (lower limit)and when to invest excess cash (upperlimit).
Depends on:
transaction costs of buying or selling securities
variability of daily cash
return on short-term investments
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The Miller-Orr Model- Target Cash Balance (Z)
3 x TC x V
4 x rZ = + L
3
where: TC = transaction cost of buyingor selling securities
V = variance of daily cash flowsr = return on short-term
investmentsL = minimum cash requirement
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Example: Suppose that short-term securities
yield 5% per year (r) and it costs the firm$50 each time it buys or sells securities(TC). The variance of cash flows is $100,000(V) and your bank requires $1,000 minimum
checking account balance (L).
The Miller-Orr Model- Target Cash Balance (Z)
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The Miller-Orr Model- Target Cash Balance (Z)
Example
3 x 50 x 100,0004 x .05/365
Z = + $1,000
= $3,014 + $1,000 = $4,014
3
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The Miller-Orr Mode
- Upper Limit The upper limit for the cash account (H) is
determined by the equation:
H = 3Z - 2Lwhere:Z = Target cash balanceL = Lower limit
In the previous example:H = 3 ($4,014) - 2($1,000) = $10,042
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Cash Budget - Problem
Rocky Mountain Climbing, Inc. (RMC) has thefollowing information:
Previous Sales November 2007 130,000December 2007 125,000
Forecast SalesJanuary 2008 120,000February 2008 260,000March 2008 140,000
April 2008 140,000
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Cash Budget - Problem
Rocky Mountain Climbing, Inc. (RMC) has thefollowing information:Previous Sales: November 2007 130,000
December 2007 125,000Forecast sales for: January 2008 120,000
February 2008 260,000March 2008 140,000
April 2008 140,000Collections : 30% of customers pay cash
50% pay in month after sale20% pay 2 months after sale
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Cash Budget - Problem
Other information for RMC Cash Budget:
Purchases of inventory are 75% of sales
and are made 2 months before saleand are paid for 1 month after delivery
Other expenses $14,000 per month
Taxes $10,000 due in March
Cash Balance (Dec. 31, 2007) = $28,000Minimum balance required by bank = $25,000(ST borrowing rate = 6% annually)
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Steps in the Cash Budget
Forecast of monthly collections andother cash inflows
Forecast of purchases and other cashoutflows
Summarize the effect on net monthly
cash flows and determine borrowingneeds or surpluses.
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Cash Budget - Collections
In each month RMC will collect cash from sales thathave occurred in that month and in the precedingtwo months.
In January, sales are 120,000
Collections: 30% x $120,000 (January sales) = 36,000
50% x $125,000 (December sales) = 62,500 20% x $130,000 (November sales) = 26,000
Total cash collected in January =$124,500
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Sales made in January will not be fullycollected until March.
Cash Budget - Collections
Collection of January Sales
Nov Dec Jan Feb Mar
Sales 130,000 125,000 120,000 260,000 140,000
36,000
120,000 x .30
60,000
120,000 x .50
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Sales made in January will not be fullycollected until March.
Cash Budget - Collections
Collection of January Sales
Nov Dec Jan Feb Mar
Sales 130,000 125,000 120,000 260,000 140,000
36,000
120,000 x .30
60,000
120,000 x .50
24,000
120,000 x .20
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Calculate collections for other months.
Cash Budget - Collections
Cash Budget
RMC, Inc.
Sales 130,000 125,000 120,000 260,000 140,000Collections:Month of Sale (30%) 36,000 78,000 42,000
First Month (50%) 62,500 60,000 130,0002nd Month (20%) 26,000 25,000 24,000Total Collections 124,500 163,000 196,000
Nov Dec Jan Feb Mar
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Payments for January Purchases
Nov Dec Jan Feb Mar
Sales 130,000 125,000 120,000 260,000 140,000
75% of January Sales Purchased inNovember
Purchases are made 2 months prior tosale and are paid for 1 month later.
Cash Budget -
Purchases/Payments
90,000
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Cash Budget -
Purchases/Payments
Payments for January Purchases
Nov Dec Jan Feb Mar
Sales 130,000 125,000 120,000 260,000 140,000
90,000 90,00075% of January Sales Purchased inNovember, Paid for in December
Purchases are made 2 months prior tosale and are paid for 1 month later.
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Calculate payments for all months.Note that in order to do a cash budget,
you will need forecasts of sales for April.
Cash Budget -
Purchases/Payments
Cash Budget
RMC, Inc.
Sales 130,000 125,000 120,000 260,000 140,000 140,000Purchases 195,000 105,000 105,000Payments 195,000 105,000 105,000
Nov Dec Jan Feb Mar Apr
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Jan Feb Mar
Cash Budget
RMC, Inc.
Cash Collections 124,500 163,000 196,000Material Payments 195,000 105,000 105,000
Summary of Previous Calculations
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Jan Feb Mar
Cash Budget
RMC, Inc.
Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000Ending Cash (No Borrow)Needed (Borrowing)Loan RepaymentInterest CostEnding Cash BalanceCumulative Borrowing
Analysis of Borrowing Needs
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Jan Feb Mar
Cash Budget
RMC, Inc.
Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000Ending Cash (No Borrow) (56,500)Needed (Borrowing)Loan RepaymentInterest CostEnding Cash BalanceCumulative Borrowing
Analysis of Borrowing Needs
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Jan Feb Mar
Cash Budget
RMC, Inc.
Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000Ending Cash (No Borrow) (56,500) 69,000Needed (Borrowing) 81,500Loan Repayment 0Interest Cost 0Ending Cash Balance 25,000Cumulative Borrowing 81,500
Analysis of Borrowing Needs
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Jan Feb Mar
Cash Budget
RMC, Inc.
Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000Ending Cash (No Borrow) (56,500) 69,000Needed (Borrowing) 81,500 0Loan Repayment 0Interest Cost 0 408Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500
Analysis of Borrowing Needs
Interest Incurred on PriorMonth Borrowing
81,500 x .005
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Jan Feb Mar
Cash Budget
RMC, Inc.
Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000Ending Cash (No Borrow) (56,500) 69,000Needed (Borrowing) 81,500 0Loan Repayment 0 43,592Interest Cost 0 408Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500
New Loan Balance
81,500 - 43,592=$37,908
Analysis of Borrowing Needs
37,908
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Jan Feb Mar
Cash Budget
RMC, Inc.
Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000 25,000Ending Cash (No Borrow) (56,500) 69,000 92,000Needed (Borrowing) 81,500 0Loan Repayment 0 43,592Interest Cost 0 408Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500 37,908
Analysis of Borrowing Needs
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Jan Feb Mar
Cash Budget
RMC, Inc.
Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000 25,000Ending Cash (No Borrow) (56,500) 69,000 92,000Needed (Borrowing) 81,500 0 0Loan Repayment 0 43,592Interest Cost 0 408 190Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500 37,908
Analysis of Borrowing Needs
Repay Outstanding LoanBalance
37,908
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Jan Feb Mar
Cash Budget
RMC, Inc.
Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000 25,000Ending Cash (No Borrow) (56,500) 69,000 92,000Needed (Borrowing) 81,500 0 0Loan Repayment 0 43,592 37,908Interest Cost 0 408 190Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500 37,908 0
Analysis of Borrowing Needs
Ending Cash Balance
$53,902-$25,000=$28,902 Surplus
53,902
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Managing Cash Inflows and
Outflows Generally managers try to increase the
amount of cash flowing into a business
during any given time period. They also try to slow down cash
outflows.
Collect early and Pay late (but not toolate).
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Managing Cash Flows
Can increase cash inflows (or speed themup) by:
Increasing cash sales
Increasing credit sales collections
Can decrease cash outflows (or slow themdown) by:
Cutting costs Taking full advantage of time allowed to pay
obligations
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Accounts Receivable
and Inventory
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Learning Objectives
How and why firms manage accountsreceivable and inventory.
Computation of optimum levels ofaccounts receivable and inventory.
Alternative inventory management
approaches. How firms make credit decisions and
create collection policies.
Why do firms accumulate
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Why do firms accumulateaccounts receivable and
inventory? Given that accounts receivable and
inventory are assets that do not provide anexplicit rate of return, it is important to
understand why firms might still want tohave these investments.
Granting credit is often an essentialbusiness practice and can enhance sales.
(But also will increase costs.) Holding adequate inventory is necessary to
avoid loss of sales due to stock-outs.
Fi di th O ti L l
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Finding the Optimum Levelof Accounts Receivable
Firms managers must review the firmscredit policies and evaluate the impact ofany proposed changes in policies based onthe NPV of incremental cash flows due tothe change.
This is similar to the method we used in
determining the best capital budgetingprojects to undertake.
Link to Hoovers Online
A t R i bl
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Accounts ReceivableManagement
The terms of sale are generally statedin the form X / Y, n Z
This means that the customer candeduct X percentage if the account ispaid withinYdays; otherwise, theaccount must be paid within Z days.
Example: 2/10 n 30 The company offers a 2% discount if
account paid in 10 days.
Balance due in 30 days.
Eff t f Ti ht i
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Effects of TighteningCredit Policy Raise credit standards
Fewer credit customers (could reduce sales) Lower accounts receivable
Shorten net due period Fewer credit customers (could reduce sales)Accounts paid sooner Lower accounts receivable
Reduce discount percentage Fewer credit customers (could reduce sales) Fewer take the discount
Shorten discount period Same as above
A erage Collection Period
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Average Collection Period(ACP)
Old Policy; 2/10, n30 35% of customers pay in 10 days
62% of customers pay in 30 days
3% of customers pay in 100 days
ACP=(.35x10)+(.62x30)+(.03x100)=25.1 days
New Policy; 2/10, n40 35%of customers pay in 10 days
60% of customers pay in 40 days
5% of customers pay in 100 days
ACP=(.35x10)+(.60x40)+(.05x100)=32.5 days
A l i f A t R i bl
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Analysis of Accts. ReceivableChanges
Develop pro forma financial statements foreach policy under consideration.
Use the pro formas to estimate incremental
cashflows by comparing forecasts tocurrent policy cash flows.
Use the incremental cash flows to estimatethe NPV of each policy change.
Choose the policy change that maximizesthe value of the firm (highest NPV).
Analysis of Accts
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Example:ABC Corporation is considering a credit policychange from offering no credit to offering 30days credit with no discount (n 30).
Why might they do this?
-Increase sales
-Increase market share
What costs will the firm incur as a result?
-Cost of carrying accounts receivable
-Potential increase in bad debts
-Credit analysis and collection costs
Analysis of Accts.Receivable Changes
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Analysis of Accts
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Analysis of Accts.Receivable Changes
Calculate the NPV of the change (k = 12%): PV of the expected inflows of $3,900 per year
from t = 0 to infinity (perpetuity)= $3,900 / .12
= $32,500
NPV = PV of inflows - initial investment= $32,500 - $28,000= $4,500
Since NPV > 0, ABC should undertake the creditpolicy change, assuming that the assumptions arevalid and that the projected cash flows areaccurate.
How Firms Make Credit
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How Firms Make CreditDecisions
The Five Cs of Credit:
Characteris the borrowers willingness to pay basedon past payment patterns.
Capacityis the borrowers ability to pay based onforecasts of future cash flows.
Capital is how much wealth the borrower has to fallback on.
Collateral is what the lender gets if the borrowerfails to pay.
Conditions faced by the borrower in the businessmarketplace are also considered.
Link to Credit Scoring
M th d f C ll ti
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Methods of Collection
Send reminder letters.
Make telephone calls. Hire collection agencies.
Sue the customer.
Settle for a reduced amount.
Write off the bill as a loss.
Sell accounts receivable to factors.
Most firms use some of the following:
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Inventory Management
Typically, inventory accounts for about fourto five percent of a firm's assets.
In order to effectively manage theinvestment in inventory, two problems mustbe dealt with: how much to order and howoften to order.
The economic order quantity (EOQ) modelattempts to determine the order size thatwill minimize total inventory costs.
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Inventory Management
Determining Optimal Inventory
Economic Order Quantity (EOQ)
Total
Inventory
Costs
=
Total
Carrying
Costs
Total
Ordering
Costs
+
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=Total
InventoryCosts
( ) CC + ( ) OC
OQ2
SOQ
Where:
OQ = Order Size (order quantity)S = Annual Sales VolumeCC = Carrying Cost per UnitOC = Ordering Cost per Order
TotalInventory
Costs
=Total
Carrying
Costs
TotalOrdering
Costs
+
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85Order Size (units)
Cost($)
Ordering Costs
= ( )OCS
OQ
Ordering Costs
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Inventory Management
The economic order quantity that
minimizes the total costs of inventory.
Determining Optimal Inventory
EOQ =2 x S x OC
CC
Inventory Management
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Inventory Management
Economic Order Quantity (EOQ)Example:
Awesome Autos expects to sell 1,200 new automobiles
in the next year. It currently costs $26 per order placedwith the manufacturer. Carrying costs amount to $75 perauto. How many autos should they order each time theyplace an order?
=
= 28.84 29 cars
2(1200)2675
Determining Optimal Inventory
EOQ =2 x S x OC
CC
Inventory Management
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Inventory Management
Determining Optimal Inventory Economic Order Quantity (EOQ)
EOQ autos in each order
Place 1,200/ 29 = 41.4 orders each year
Example:Awesome Autos expects to sell 1,200 new automobiles
in the next year. It currently costs $26 per order placedwith the manufacturer. Carrying costs amount to $75 perauto. How many autos should they order each time theyplace an order?
Inventory Management with Safety
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y g yStock- Order before inventory is at
zero.
EOQ
Depleted Stock
During Delivery
Inventory Order Point
Actual Delivery Time
SafetyStock
Time
Inventory
Level
(units)
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ABC Inventory
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ABC InventoryClassification System Tool to reduce inventory carrying costs:
classify different types of inventoryaccording to value.
Example: Class A: Expensive items are assigned a serial
number and are checked daily. Replaced only assold.
Class B: Moderately priced items are assigned aserial number but are checked less often(monthly) and managed according to EOQ.
Class C: Small inexpensive items. Checkinventory annually and reorder by visual check.
Just In Time Inventory
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Just In Time InventoryControl (JIT)
Developed in Japan.
Reduce raw material inventory carryingcosts by making deals with suppliers thatrequire them to deliver the raw materials asneeded.
Carrying costs are passed on to suppliers.
Can result in higher costs if delivery isdelayed: shut down of whole productionline.
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Short Term
Financing
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Why Do Firms Need
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Why Do Firms NeedShort-term Financing?
Profits may not be sufficient to keep up withgrowth-related financing needs.
Firms may prefer to borrow now for their
needs rather than wait until they havesaved enough.
Short-term financing instead of long-termsources of financing due to: easier availability
usually lower cost
Sources of Short-term
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Sources of Short termFinancing
Short-term loans.
borrowing from banks and other financial
institutions for one year or less. Trade credit.
borrowing from suppliers
Commercial paper. only available to large credit- worthy
businesses.
Types of short-term
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Types of short termloans:
Promissory noteA legal IOU that spells out the terms of the loan
agreement, usually the loan amount, the term of
the loan and the interest rate. Often requires that loan be repaid in full with
interest at the end of the loan period.
Self-liquidating loan
The proceeds of the loan are used to acquireassets that generate cash to repay the loan (e.g.inventory).
Types of short-term
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Types of short termloans:
Line of Credit The borrowing limit that a bank sets for a firm. May include many promissory notes that the firm
has taken out at different times and withoverlapping payment periods.
Usually informal agreement and may changeover time
Revolving credit agreement
Formal agreement with bank to extend credit toa firm for a period of time (can be more thanone year).
T d C di
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Trade Credit
Trade credit is the act of obtaining funds bydelaying payment to suppliers.
Even though it is obtained by simply delayingpayment, it is not always free.
The cost of trade credit may be some interestcharge that the supplier charges on the unpaidbalance. More often, it is in the form of a lostdiscount that would be given to firms who payearlier.
Credit has a cost. That cost may be passed alongto the customer as higher prices, borne by theseller as lower profits, or some of both.
Estimation of Cost of
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Estimation of Cost ofShort-Term Credit Calculation is easiest if the loan is for a one
year period:
Effective Interest Rate is used to determine thecost of the credit to be able to comparediffering terms.
Effective
Interest RateInterest you pay
Amount you get to use=
Example: You borrow $10,000 from a bank and must pay $1,000interest at the end of the year
Your effective rate is the same as the stated rate= $1,000/$10,000 = .10 = 10%
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V i ti i L T
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Variations in Loan Terms
Sometimes lenders require that a minimumamount, called a compensating balance bekept in your bank account.
If your compensating balance requirementis $500, then the amount you can use isreduced by that amount.
Effective cost for a $10,000 simple interest
10% loan with a $500 compensatingbalance = $1,000/($10,000-$500) = .1053= 10.53%.
Cost of Short-Term Credit
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Cost of Short Term CreditFor Periods Less Than One Year
When loans are for less than one year, we mustconvert the cost to annual terms for comparison.
e.g. A 1 month $10,000 loan requires that interest
of $90 be paid:the monthly rate = 90/10,000 = .0090 = .9%.
Use the following formula to equate:
Effective
Annual =
Rate1 + -1
$ Interest$ you get
to use
(Periods/yr)( )
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Cost of Short-Term Credit
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Cost of Short Term CreditFor Periods Less Than One Year
What if the loan is a discount loan? Mustpay the interest up front so that reduces thedollars available to use.
$10,000 loan with .9%monthly interest:
K=(1+ 9010,000 - 90
)12
-1 = .1146
k = 11.46%
Effective annual rate
Sources of Short Term
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Sources of Short TermCredit
Cost of Trade Credit
Typically receive a discount if you pay
early. Stated as: 2/10, net 60
Purchaser receives a 2% discount if paymentis made within 10 days of the invoice date,
otherwise payment is due within 60 days ofthe invoice date.
The cost is the form of the lost discount.
Cost of Trade Credit 2/10
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Cost o ade C ed t / 0net 60
Assume your purchase is $100 list.
If you take the discount, you pay $98.
If you dont take the discount, you pay$100.
Therefore, you are paying $2 for the
privilege of borrowing $98 for theadditional 50 days. (Note: the first 10days are free in this example).
Cost of Trade Credit 2/10 net 60
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The formula for cost of trade credit is similar tothe previous equations.
The exponent is the number of times per yearthe firm can take 50 days of credit.
The cost of trade credit for this example:[1 +(2/98)])7.3 -1 = .1589 = 15.89%.
Cost of Trade Credit 2/10 net 60
Cost
of Credit
Discount %100-Discount%
1 + -1365
days to pay - disc. pd.( )=((
Computing the Cost of TradeC dit
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Credit
Another Example Effective Annual Cost, k, of Passing Up
a Discount; 2/10, n40
K =(1+ 2100 - 2 )( 36540 10 )
-1 = .2786
k = 27.86%
Commercial Paper
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Commercial Paper
Commercial paper is quoted on a discountbasis so discount yield must be converted toeffective annual interest rate forcomparison.
Compute the discount from face value (D) D = (Discount yield x par x DTG)/360 DTG = days to go (to maturity)
Compute the price = Par - D Compute Effective Annual Rate
= (par/price)(365/DTG) - 1
Cost of Commercial Paper
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pExample
$1 million issue of 90 day c.p. quoted at 4% discount yield.
Step 1:Calculate D = .04 x $1 mill. x 90360
= $10,000
Step 2:Calculate price= $1,000,000 - $10,000= $990,000
Step 3:Calculate effective rate
= (1,000,000 / 990,000)
(365/90)
-1= 4.16%
Accounts Receivable as
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Collateral
A pledge is a promise that the borrowingfirm will pay the lender any paymentsreceived from the accounts receivablecollateral in the event of default.
Since accounts receivable fluctuate overtime, the lender may require certainsafeguards to ensure that the value of thecollateral does not go below the balance of
the loan. Accounts receivable can also be sold
outright. This is known as factoring.
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Inventory as Collateral
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Inventory as Collateral
Blanket Lien: A general claim against theborrowers inventory if there is a default
Trust Receipt: A legal document thatidentifies specific inventory as security for aloan
Warehousing: Inventory pledged as
collateral is removed from the control of theborrower (either in an on-site or publicwarehouse)